Fun with Fed Funds

So if you pay attention to any financial news you've heard that the Fed raised interest rates again.

Most people don't actually know what this means other than higher rates = bad. To be fair, that's not wrong exactly.

As of the last meeting, the fed funds rate is the range of 4.25 - 4.50%. Most people use the lower bound and just call it 4.25%.

The Federal Reserve's decision to change the interest rate it pays on reserves held by banks (known as the interest rate on excess reserves, or IOER) can have significant effects on the wider economy. The IOER is one of the primary tools the Federal Reserve uses to influence the overall level of interest rates in the economy and control the money supply.

When the Federal Reserve increases the IOER, it becomes more attractive for banks to hold their excess reserves at the Fed rather than lend them out to borrowers. This can reduce the supply of loanable funds in the economy, leading to higher interest rates and slowing down borrowing and spending. Conversely, when the Federal Reserve lowers the IOER, banks are more likely to lend out their excess reserves, increasing the supply of loanable funds and lowering interest rates, which can stimulate borrowing and spending.

Changes in the IOER can also affect the yield curve, which shows interest rates for bonds of different maturities. A steeper yield curve can signal that economic growth is expected to pick up in the future, while a flatter yield curve can indicate a more cautious outlook for economic growth. And an inverted curve can indicate that market participants are expecting recession in the short term.

Notice we have gone from a normal sloping yield curve a year ago (red line) to an inverted curve today (blue line).

In addition to affecting borrowing and spending, changes in the IOER can also have a direct impact on the financial markets. For example, a change in the IOER can influence the prices of bonds and other fixed-income securities, as well as the value of the currency.

Bottom line, the Federal Reserve is setting the opportunity cost to the banking system. If a bank can make a guaranteed 4.25% then the only way it would make a loan is to charge a higher rate after factoring in defaults and administration costs. This is why 30-year fixed mortgage rates are 6.55% today. The higher the opportunity cost (fed funds rate) the lower the incentive for banks to finance economic activity. The less economic that gets financed, the worse off the economy is.

On the retail side, the yield curve sets the baseline opportunity cost. If I can get 4.75% on a 6-month treasury note, any speculation I want to do needs to be compared against that. In crypto terms, my opportunity cost is based on 20% HBD.

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